Profitability

Recent Enhancements to Small Cap Investment Strategies

Profitability

One of the reasons we at Index Funds Advisors advise using funds from Dimensional Fund Advisors is that Dimensional never stops seeking ways to add value for their investors. Drawing from a deep bench of professional researchers who are guided by luminaries such as Eugene Fama and Ken French, Dimensional often finds things that may have been missed by other players in the investment industry. Two findings that we believe will enhance small cap fund returns are presented below.

Small cap growth is an asset class that we have avoided because its volatility is not commensurate with its expected rate of return when compared to other asset classes. Dimensional’s research has identified a particular subset of small cap growth stocks that has had especially poor relative performance, the corner of the market referred to as “extreme small growth” which accounts for about 10% of the approximately 2,500 eligible small cap stocks. Identifying the extreme small growth companies requires an evaluation of not only the price-to-book ratio but also the price-to-earnings ratio and the price-to-cash flow ratio. While the historical underperformance of these stocks has been documented, no satisfactory explanation has been offered. In this respect, it is similar to the momentum effect. Dimensional’s research also found that the poor performance of extreme small growth exists in markets outside the U.S. In response, Dimensional has implemented exclusionary filters on all of its small cap and core funds. Over the 37-year period ending 12/31/2011, these exclusions would have added about 0.9% to the annualized return of a domestic small cap index fund. For an international small cap index fund, the impact on returns was similar for the 17-year period studied. In both cases, the lower returns of the extreme small growth stocks were found to be statistically significant at a 95% confidence level.

The second enhancement pertains to securities lending, which is the act of lending out a stock for a fee so that the borrower can short-sell it. Dimensional has traditionally utilized this technique to create a stream of revenue that has increased returns for DFA fund investors. We view it as one of the ways that indexers benefit at the expense of active investors. Dimensional’s research recently found that small cap stocks that are highly in demand by short-sellers (as measured by their willingness to pay a higher-than-normal fee) tend to underperform relative to their peers for the next few weeks. Like momentum, the degree of underperformance is not high enough to overcome trading costs (i.e., liquidating the stock to replace it with a different stock), but it does argue that buying these companies should be avoided while the short-sellers are seeking lenders. Again, the reason for the underperformance is unknown, but it does suggest that the short-sellers may be acting on information that has not been fully dispersed in the market. One thing we have learned from recent hedge fund scandals such as SAC Capital and the Galleon Group is that hedge funds live and die based on their informational edge. Sometimes, it is better not to take the other side of their trades.

As an investment fiduciary, IFA will continue to keep abreast of developments in finance to ensure that our clients have the best possible investment experience that we can provide. If you have any questions on small cap investing or any other investment-related topic, please feel free to drop us a line at [email protected].